Plan rewrites derivatives taxation with mark-to-market

Gains and losses would be recognized annually

Many derivatives would be required to be marked to market for tax purposes, under a draft proposal from Representative Dave Camp, the Republican chairman of the House Ways and Means Committee.

Requiring taxpayers to mark to market would mean they would have to recognize gains and losses each year for their financial products, rather than waiting until an asset is sold or exchanged. The mark-to-market rule wouldn’t apply to derivatives used in business transactions to hedge against risks related to price, currency and interest rates. It also wouldn’t apply to stocks or bonds.

Camp’s draft, which implements ideas that have consensus among many tax lawyers who work in the field, is the most radical proposal in financial products taxation since the income tax was created, said Viva Hammer of Brandeis University, who was responsible for financial products tax policy at the Treasury Department from 2000 to 2006.

“It’s a revolutionary change,” she said in an interview today. “It really uproots the entire labyrinth of financial products rules and puts a single rule in its place.”

The proposal also would repeal the current “60/40 rule” that allows some investors to treat 60 percent of their gains as long-term capital gains, which get a preferential rate. Under the proposal, gains and losses on derivatives would be taxed as ordinary income.

Broader Effort

Camp unveiled the draft today as part of his effort to overhaul the tax code and lower tax rates on ordinary income and corporations, and the impact of repealing the 60/40 rule can’t be fully estimated until he sets the tax rates. Under current law, the top rate on ordinary income is 39.6 percent and the top rate on capital gains is 23.8 percent.

“If we are to enact tax reform that preserves needed flexibility in the financial markets while ensuring that no one is gaming the system and putting hard-working taxpayers at risk, then we will need the expertise of those who are most familiar with these products,” Camp, of Michigan, said in a statement. “They can identify areas that merit additional attention, and their insight is critical.”

A 2011 report by Congress’s nonpartisan Joint Committee on Taxation said taxpayers can use derivatives and other financial products to take advantage of gaps in the tax system.

Financial Crisis

“The tax code played a role in the financial crisis,” said Sage Eastman, a spokesman for Camp. “This will go in, make sure we have a clean, transparent set of rules that Wall Street will play by.”

Mark-to-market taxation has some potential drawbacks, namely definitional questions about how to define the value of the derivativesand liquidity concerns that people will be taxed on money they don’t have.

“It doesn’t make any sense,” said Allan Zavarro, the former global head of futures trading for ABN Amro Bank NV.

A trader could have a profit of $100,000 on interest-rate futures in December that would get caught by the tax, he said. When that position expires in June the next year, the position ultimately may have lost money, though the trader paid the tax as though he earned a return.

“You can be obligated for a tax on positions that aren’t profitable,” he said.

Eastman said the committee doesn’t have a revenue estimate for the proposal, and it could either raise money for the government or cost money, depending on how else tax laws are rewritten.

Raising Revenue

Representative Sander Levin of Michigan, the committee’s top Democrat, said he welcomed Camp’s proposal as a possible way to raise revenue while ending inequities.

“This underlines the need for us to act on a bipartisan basis to raise revenues and close loopholes as we seek further deficit reduction through a balanced package of spending cuts and additional revenues,” Levin said in a statement.

The notional size of the over-the-counter derivatives market was $639 trillion as of June 2012, according to the Bank for International Settlements, a Basel, Switzerland-based organization that tracks derivatives.

Brookly McLaughlin of Intercontinental Exchange Inc. declined to comment. Laurie Bischel, a spokeswoman for CME Group Inc., said she hadn’t read the proposal and had no immediate comment. CME Group, based in Chicago, is the world’s largest futures exchange. Atlanta-based Intercontinental owns the second-largest U.S. futures market.

Second Draft

The proposal is the second such discussion draft from Camp, who detailed changes to the international tax system in 2011. He has said his committee will pass a revenue-neutral tax code overhaul in 2013 that addresses the individual and corporate tax systems.

Today’s draft also proposes that holders of bonds bought on the secondary market at a discount must recognize income in the same way as taxpayers who purchase directly from issuers.

It would also modify the so-called wash-sale rules to prevent taxpayers from selling financial products at a loss and then repurchasing them. Taxpayers would no longer be able to have relatives or related companies make the second purchase.

For all securities, including stocks and bonds, the draft would require the use of average cost basis to calculate gains as opposed to allowing taxpayers to choose specific shares to sell. Average cost basis means using the average price paid for a security, even if the security is purchased in multiple batches.